Wednesday, May 31, 2017

Robo-Advisors - The Future of the Investment Industry

recent study by the CFA Institute (Chartered Financial Analysts) looks at the future of the investment profession.  The CFA Institute is a global, not-for-profit organization and is the world's largest association of investment professionals.  Currently, there are approximately 2 million workers in the investment industry, managing around $100 trillion in assets for clients.  The report looked at the findings from a survey of 1145 investment industry leaders , looking at the trends that will impact the investment business in the future.  Here are some of the more interesting findings, particularly those related to how the investment industry will have to adapt to changes in the marketplace.

Respondents were asked to rank the future importance of the following ten skills:

1.) Ability to articulate a compelling vision for the institution.
2.) Ability to instill a culture of ethical decision making 
3.) Consultative selling skills 
4.) Crisis management skills 
5.) International and cross-cultural skills (including foreign languages) 
6.) Knowledge of science, engineering, and mathematics 
7.) Relationship-building skills 
8.) Sophisticated knowledge of IT (e.g., programming, artificial intelligence) 
9.) Specialized financial analysis skills
10.) Understanding of corporate governance/regulations

Here are the results:

Note that only 20 percent of the CEOs of asset management firms believed that analysis skills will be important over the next five to ten years.  This says a great deal about where the investment industry is headed as you will see in the following paragraphs.  According to the study, 70 percent of respondents expected that investors will increase their allocations to "passive investment vehicles".  This strategy involves maximizing returns by reducing the amount of buying and selling by investing in funds that mirror the market indices.  Passive investing has also been referred to as "investing on autopilot" since very little input by either the client or the investment professional is required.  The study notes that passive funds are offered as "loss leaders" and are used to attract customers to value-added products like estate and retirement planning among others.  The leaders of the investment industry also note that "robo-advice" and its cyborg variants are becoming the preferred tool for delivering investment advice to clients.  Because of the amount of data involved, robotics, smart algorithms, machine intelligence and artificial intelligence are becoming increasingly important to automate services offered in the investment industry.  Here is a quote:

"In a world where the cost of information discovery races to almost zero, the speed of parsing this data also increases far beyond human capability. Enter machine intelligence. Combining these things with consistency and freedom from human bias is a recipe for significant disintermediation.

The informational gains from big data can flow from natural language query, plus the combination of predictive and prescriptive analytics, driven by computers whose hardware and software architectures are designed to emulate human thinking. In short, if what a financial professional does relies on a formula, then it is ripe for disintermediation and margin erosion as machine intelligence, coupled with big data, takes over. Examples of formulaic activities in finance include financial statement analysis, reading annual reports, listening to earnings calls, valuation, and trading.

Of course, finance has always relied on judgment and drawing valid inferences from data, which is the good news for financial jobs. But finance professionals do suffer from cognitive biases and limitations, and machine learning is designed to de-bias subject matter. “Technology is an asset,” says a CFA charterholder who manages a $20 billion portfolio at a Canadian asset management firm. “It doesn’t have to be a threat. You should be strong enough in your convictions to be able to use that technology to better service your clients.”"  

So, what does the future look like according to investment industry leaders?  They see an investment industry future with far less human involvement, rather, using robo-advisors:

"Robo-advisers are basically a class of financial adviser/intermediary that provides portfolio management with minimal human intervention. Instead of human-based active portfolio management and asset allocation, extensive customer questionnaires about finances, coupled with passive management strategies and asset allocation algorithms, are used to construct investment portfolios....Robo-advice and its variants become preferred style or tool for delivering investment advice and execution to much of the retail/ private wealth segment. "

So, what is the bottom line?  The study notes that there are both benefits and drawbacks to automated financial advice.  The benefits include lower costs and greater access and the risks include market fraud, mis-selling of products and lower quality of service.  The study also notes that robots-funds will become core to the private wealth management field.  That said, the biggest benefit to the investment industry is the drop in costs to the industry itself since  it will require far fewer credentialed financial professionals who expect to make a healthy living off of their commissionable transactions.  The pending lack of human intervention means that services can be offered for much lower costs than those that have been experienced in the past.

Let's close with this quote:

"Given the powerful combination of big data, combined with machine intelligence, it becomes very easy for highly refined, goal-specific asset allocations to become possible. For example, imagine a world in which the unique risks identified by a customer are mitigated by a customized, algorithm-created, derivative product with a complicated design but noncomplex and user-friendly engagement."

Robo-advice appears to be the future of the investment industry whether we like it or not.  While it may provide investors with lower costs, there are significant downsides to the reliance on artificial intelligence in the investment industry, the home of trillions of investors's life savings.   No matter how "smart" artificial intelligence becomes, it still is completely incapable of predicting human behaviour, particularly the type of random emotional behaviour that occurs when investors perceive that the market is about to crash. 

Tuesday, May 30, 2017

Have We Entered the Corporate Debt Danger Zone?

Thanks to the Federal Reserve and its central bank peers, the world is now awash in debt.  This is particularly the case in the corporate sector where debt has been accrued to record levels, an issue that is of concern, particularly when one of two scenarios play out; a rise in interest rates or a slowing of the economy.  In the most recent version of theInternational Monetary Fund's Global Financial Stability Report for April 2017, the IMF takes a detailed look at the global corporate sector debt levels and expresses concerns over the worsening debt serviceability issues.  In this posting, we'll look at the debt situation for the corporate sectors in both the United States and take a brief look at the corporate debt situation in the world's emerging economies.

The IMF begins by noting that the U.S. corporate sector has added $7.8 trillion in debt and other liabilities since 2010 with traditional equity financing being outstripped by share buybacks as you can see here:

Here is a graphic showing how the net leverage (ratio of net debt to EBITDA or earnings before income tax, depreciation and amortization) for big corporations in the United States:

As you can see, median corporate leverage among large corporations has grown steadily since the end of the Great Recession and is now close to historically high levels at 1.5 times earnings.

Here is a graphic showing net leverage for key sectors of the economy, comparing the level in 2004 to 2006 to the level in 2016:

Eight out of ten sectors showed an increase in leverage with only two showing a decrease over the decade; industrials and real estate, although the net debt of these three sectors is still very high.

Here is a graphic showing the debt service burden (red line) for the American corporate sector:

Despite the current ultra-low interest rate environment, the debt service burden for Corporate America has risen substantially since 2015.

Here is a graphic showing interest rate coverage ratios (ratio of EBIT (earnings before income tax) to interest payments):

As you can see, higher interest rates could push the interest rate coverage ratio downwards even further, significantly weakening the ability of corporations to cover interest owing on their debt.

Here is a graphic showing the percentage of firms at risk of default:

At 22.1 percent, the percentage of firms that are at risk of default is at the highest level since the turn of the millennium.

Now, let's take a brief look at the corporate sector debt situation in the world's emerging market economies.  Here is a graphic showing which nations have corporate debt that is at risk (i.e. interest coverage ratio of less than 1) should global trade decline, economic growth decrease and protectionist trade pressures rise:

Corporations in nations that rely heavily on manufacturing and commodity exports are particularly vulnerable to increases in debt risk since they are the economies that will be impacted the most by protectionism as shown here:

As we can see from this report, thanks to the current ultra-low interest rate fantasy land, the corporate sector in both the United States and the world's emerging market economies is highly vulnerable to changes in interest rates, largely because it has gorged itself at the cheap debt trough.  Earnings have dropped to less than six time interest expense, a level that is close to the lowest levels seen during the Great Recession.  While many of these troubled firms are in the beleaguered energy sector, firms in both the real estate and utilities sector are showing debt pressures as well.  Under a scenario where there is a sharp rise in interest rates, the IMF projects that the combined assets of debt challenged American firms could reach almost $4 trillion, a scenario that does not bode well for investors, particularly those that have invested in high yield corporate debt. 

Monday, May 29, 2017

Breaking Down the Global Economy

We regularly hear that China is catching up to the United States when it comes to the size of its economy, an issue that is of particular concern to the Trump Administration.  While the gap may be closing, according to recent data from the World Bank, China's GDP still lags well behind that of the United States as shown on this recent listing showing data for the 183 largest economies from 2015:

The gap of $7.029 trillion between the United States and China is still very substantial with the U.S. having 24.32 percent of the world's $74.152 trillion economy compared to 14.84 percent for China.  Formerly number two finisher, Japan, has fallen to third place and now contributes only 5.91 percent of the global GDP, well less than half of China's contribution.  It is also quite apparent how massive the output gap is between the major economies and those that contribute less. 

While looking at the data is kind of boring, the folks at have created this rather interesting graphic, showing the global economy in a Voronoi diagram as shown here:

The American economy is approximately the same size as the combined economies of the third through tenth largest economies combined; Japan ($4.38 trillion), Germany ($3.36 trillion), United Kingdom ($2.86 trillion), France ($2.42 trillion), India ($2.09 trillion), Italy ($1.82 trillion), Brazil ($1.77 trillion) and Canada ($1.55 trillion).

Looking at the global economy by continental region, we find the following:

Asia - 33.84 percent of global GDP
North America - 27.95 percent of global GDP
Europe - 21.37 percent of global GDP

That leaves the remaining regions including Africa, South America and Australia sharing 16.84 percent of the global economy.  As well, the 40 largest economies in the world produce 90.6 percent of global economic output; this leaves more than 100 nations sharing the remaining 9.4 percent of the global economy.  Even nations like India, the second-most populous nation on earth with its 1.337 billion people, contributes only 2.38 percent to the total global economy.

In closing, there is one additional way to look at the World Bank database; by national income level.  Here is a breakdown of total GDP in dollars and share of global GDP for each national income level:

Low income - $394.2 billion or 0.53 percent
Lower middle income - $5.861 trillion or 7.9 percent
Upper middle income - $20.492 trillion or 27.6 percent
High income - $47.412 trillion or 63.9 percent

Despite the perception that the emerging economies of the world are taking over the global economy, the numbers clearly show that they have a long way to go before they are a significant threat to the world's advanced economies.  

Friday, May 26, 2017

Supporting the American Defense Industry

In Donald Trump's recent speech in Saudi Arabia, he stated the following:

"King Salman, I thank you for the creation of this great moment in history, and for your massive investment in America, its industry and its jobs. I also thank you for investing in the future of this part of the world."

This speech was given after Saudi Arabia signed a deal to purchase $110 billion worth of arms effective immediately and $350 billion over ten years.  While it's interesting to see that President Trump thanked Saudi King Salman for his contribution to American industry and jobs, there is a group of people that should receive even greater thanks for their contribution to the U.S. defense industry - American taxpayers.

On the Federal Procurement Data System website, we can access an annual listing of the top 100 contractors when measured using government-wide spending data.  Looking through this data, we can see just how much the American military-industrial complex should be thanking U.S. taxpayers for their beneficence.  Let's look at who has benefited over the past three years with 2015 being the latest year for which data is available:

1.) 2015: In total, there were $238.544 billion in contracts across all federal government departments.  The top five vendors were all defence contractors and were recipients of $90.291 billion worth of contracts or 37.8 percent of federal contract spending.  Here is a bar graph showing the total size of the contracts for the top five contractors:

The biggest recipient, Lockheed Martin, received contracts worth $36.26 billion or 8.3 percent of total federal contract spending.

2.) 2014: In total, there were $235.933 billion in contracts across all federal government departments.  Again, the top five vendors were defence contractors and were recipients of $90.074 billion worth of contracts or 38.2 percent of all federal contract spending.  Here is a bar graph showing the total size of the contracts for the top five contractors:

Again, the biggest recipient was Lockheed Martin which received $32.230 billion or 7.26 percent of total federal contract spending.

3.) 2013:  In total, there were $255.638 billion in contracts across all federal government departments.  Once again, the top five vendors were defence contractors and were recipients of $102.453 billion worth of contracts or 40.1 percent of all federal contract spending.  Here is a bar graph showing the total size of the contracts for the top five contractors:

Not surprisingly, the biggest recipient was Lockheed Martin which received contracts worth $44.114 billion or 9.64 percent of total federal contract spending.

Let's drill down a bit into the 2015 data, focussing on the contracts given to Lockheed Martin by various parts of the Department of Defense showing the total size of all contracts granted as well as the percentage of spending for that category:

Navy - $15.524 billion (18.4%)
Army - $4.039 billion (5.6%)
Air Force - $7.394 billion (14%)
Defense Threat Reduction - $40.228 million (4.2%)
Defense Microelectronices - $32.472 million (6.4%)
Defense Information - $367.726 million (7.4%)
Defense Advanced Research Projects Agency - $198.726 million (19.7%)
Missile Defense - $935.529 million (19.9%)
Special Operations - $656.413 (22.5%)

Even Homeland Security jumped onto the Lockheed Martin bandwagon, granting contradicts worth $327.036 million in 2015.

As you can clearly see from the data shown in this posting, the American military-industrial complex and the President of the United States should not be thanking the Saudi Royal Family for their "investment in America, its industry and its jobs" rather, they should be thanking the taxpayers of the United States who have sunk trillions of dollars into their businesses over the decades, particularly since the endless War on Terror began in 2001.  In particular, the 97,000 employees at Lockheed Martin should be thankful that the Department of Defense has chosen the products that they manufacture to arm the U.S. military.  And, just in case you thought that I'd forgotten the company's named executive officers, here are a few more corner office dwellers from Lockheed Martin that should be thankful to U.S. taxpayers: